The present invention relates generally to financial planning and more particularly to a method for developing a financial model that incorporates a time horizon.
In financial planning, a time horizon or investment horizon refers to the time frame in which an individual will be investing. It is a generally accepted principle that investments used for fulfilling near-term financial objectives should be more conservative than investments used for fulfilling long-term financial objectives. The basis for this investment strategy is that a longer time horizon provides sufficient time to ride out the market's periodic swings. Suppose, for example, that an individual wishes to save money for a single financial event expected to occur at a specific point in time, a trip to Europe in 25 years. The initial time horizon is 25 years. However, as the years pass, the time horizon decreases, so in five years, the event will be 20 years away, and in 10 years, the event will be 15 years away, and so on. As the time horizon of the event changes, so should the investment of the funds being saved for the event. Therefore, what may start out to be a long term, fairly aggressive investment strategy where a large amount of money is being invested in stocks should gradually become a short-term, fairly conservative investment strategy where a large amount of money is being invested in short-term reserves. However, the exact mix of asset classes that are invested in depends on the individual's attitude toward risk. Stocks are more risky assets with a higher expected return and short-term reserves are less risky with a lower expected rate of return. As the mix of asset classes change, the overall expected rate of return will decrease. Therefore, it is unreasonable to assume a constant, fixed rate of return over the life of an investment, when that investment is planned for attaining a specific future objective.
While it is common to state the general relevance of time horizon when introducing an individual to the principles of investing, no attempt is usually made to take into account the effect of a changing time horizon when estimating the rate at which savings should be invested in order to prepare for future expenditures associated with fulfilling future financial objectives. Currently available financial models aimed at assisting individuals in making reasonable financial investment decisions focus on the individual's attitude towards risk or risk aversion. The time horizon of the individual is often treated as a secondary consideration and captured as a single value (i.e., the average time horizon at the present time). This single value is then used in various ways along with the individual's risk attitude to help the investor identify a portfolio comprising of a mix of asset classes appropriate for attaining the future financial objectives. In other approaches, the mix of asset classes is used along with historical market data to determine what rate of return the portfolio of asset classes would have attained in the given historical setting. Market forecasting is then used to identify an expected rate of return for the given portfolio, which is generally assumed to be constant. The rate of return is then used to determine the rate of savings (i.e., weekly, monthly, yearly, etc.) required at the assumed rate, assuming inflation and taxes, in order to achieve a future value sufficient for the expected cost of one or more financial objectives.
Since the currently available financial models do not accurately take into account the effect of a changing time horizon, the generated expected rate of return will not be correct since it will be assumed to be constant throughout. This prevents the individual from achieving a future value sufficient to fulfill their desired financial objectives. Therefore, there is a need for a method of developing a financial model that takes into account the effects of a changing time horizon in a general and consistent manner so that if assumptions were met, an individual would be able to achieve a future value sufficient for the expected costs of fulfilling one or more financial objectives.